Very interesting article, thanks.
I saw that Hussman made a few other observations of interest. Especially, valuations are not consistent with a bottom, and they were not in March, either. We have to go considerably lower to achieve valuations typical of a market bottom.
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Comfortable with Uncertainty
John P. Hussman, Ph.D.
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Are stocks in a bull market or is this still a bear market? Frankly, I don't put much energy into that question. The S&P 500 has now corrected about one-quarter of its prior losses. Bear market corrections of about one-third are not unusual, but I wouldn't bank on that. Having failed to do anything effective to mitigate the second wave of foreclosures that is set to begin later this year, and seeing very little sponsorship in trading volume (despite good breadth), my impression is that we most likely are in a strong correcting rally in the context of an ongoing bear market. At the same time, cash-equivalents are yielding next to nothing, so it's unclear to what extent investors will decide that stocks are their only real alternative, which might allow a continuation of this advance.
....What we can observe is that valuations are now in the high-normal range on the basis of normalized earnings. Stocks are no longer undervalued except on measures that assume that profit margins will permanently recover to the highest levels in history (in which case, stocks would still only be moderately undervalued). For instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but those prior peak earnings from 2007 were based on record profit margins about 50% above historical norms, largely driven by the excessive leverage that has since sent the economy reeling.
On normalized profit margins, valuations are above the historical average, and prospective long-term returns are below the historical average. Overall, I expect the probable total return on the S&P 500 over the coming decade to be about 8% annually, provided we don't observe much additional deleveraging in the economy. At the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was priced to deliver 10-year total returns of about 15% annually. While it has become quite popular to talk about 1974 and 1982, the stock market is presently not even close to those levels of valuation.
Meanwhile, market action in recent weeks has been excellent from the standpoint of breadth (advances versus declines), uneven from the standpoint of leadership (where much of the strength has been focused on speculation in companies with extraordinarily poor balance sheets), and rather uninspiring on the basis of trading volume.
From an economic standpoint, the main argument for an oncoming recovery is simply that the knuckles of investors and consumers are no longer absolutely white. A backing-off from extreme risk aversion is certainly helpful, since it puts banks at less risk of customer flight, but the underlying assets of banks are still deteriorating. For the time being, the recent revision in accounting rules has prevented balance sheets from showing negative capital and revealing insolvency, but the reality is that the mortgages underlying bank assets are still defaulting. If this was simply a temporary problem of fluctuating asset values that would recover over time, the problem would not be serious. As T. Boone Pickens once said, “I have been broke three or four times, but fortunately for me I'm not an MBA, so I didn't know I was broke.” But the assets Pickens owned moved in cycles, and regularly recovered in step with the price of oil. In the case of mortgages, once the loan goes into foreclosure, there's an asset sale, the loss is taken, and the game is over.
Overall, then, the fundamentals of the market and the economy are not nearly as positive as they are being spun by analysts. Stocks are at best only moderately undervalued if one assumes that profit margins will recover to the historical extremes we saw in 2007, and are otherwise mildly overvalued. The financial system is in cosmetic remission, looking better on the surface, but still deteriorating internally. Still, we can't discard the fact that the extreme risk aversion of recent months has eased. Breadth has been quite strong, but is also overbought (with over 80% of stocks above their 20-day and 50-day averages). The mixed picture offers neither certainty that the bear market will resume, nor that a bull market will emerge.
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